Ownership, Investment and Governance: TheCosts and Benefits of Dual Class Shares

Ronald Masulis,University of New South Wales, Australia

&Suman Banerjee,

University of Wyoming.

Global Corporate Governance Colloquia,June 5-6, 2015

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Motivation

Objective of our paper...

To further our understanding of the link between ownership structure,governance and the investment decision

I Governance evolves as an endogenous shareholders’ choiceI Separation of cash flow rights and voting rights alleviates an

under-investment problem

Prior theoretical research concludes that dual-class share structureleads to lower efficiency in the market for corporate control

Impact of separation of voting and dividend rights on a firm’sinvestment decision has not been analyzed

We analyze a firm facing a potential takeover threat from a rival firmwith a manager-controlling shareholder

I We develop our theory in a rational contracting environment withcontrol rents.

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Motivation

Use of Voting Shares & Debt

When a manager owns voting shares andI the firm issues new voting shares to finance a scale-expanding

investmentI The manager suffers dilution of his/her ownership position

This increases the risk that the manager can lose control of the firmI Reduces his/her expected private benefits of control and expected

wealth.

Debt does not solve the underinvestment problem.I This is so because debt carries with it the risk of bankruptcy and the

incumbent risks a loss of control from violating a covenant.

As a consequence, the manager may forgo some positive NPVinvestments in order to protect his control rights.

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Motivation

Potential Benefits of Non-voting Shares

Under-investment is costly for the existing shareholders and reducesfuture dividends.

Non-voting shares allow a firm to raise investment fundsI without diluting the manager’s control rights, orI without issuing more debt which can require stricter covenants.

Hence, non-voting shares help to alleviate the under-investmentproblem.

Also, issuance of non-voting shares raise the takeover premium onexisting voting shares conditional on a bid, since the total premium isnow divided among a smaller group of shares with voting rights.

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Motivation

Potential Costs of Non-voting Shares

1 Dividend dilutionI All shares pay the same dividend per shareI But non-voting shares do not get potential takeover premiumsI Hence, the market price of voting shares > the market price of

non-voting sharesI Thus, a relatively larger number of non-voting shares must be issued to

raise the same amount of investment funds.

I Hence, the per share dividend for existing shareholders (including theincumbent) is lower relative to issuing a smaller number of votingshares for the same total dollar of dividends.

2 Management entrenchmentI Private benefits plays a bigger role in the control contestI It lowers probability of a takeover as lower “quality” managers can use

their private benefits to thwart value enhancing takeover bids.

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Motivation

Main Intuition...

The issuance of non-voting equity can be optimalI when the benefits of higher investment outweigh the costs of

managerial entrenchment and significant dividend dilution

We obtain conditions under which it is optimal for firms to issuenon-voting stock for both outside shareholders and the incumbent

Our model produces new empirical predictions regardingI the relationship between firm valuation, and the likelihood of dual-class

recapitalization, which are functions ofF incumbent management qualityF management ownershipF management private benefits

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Motivation

Prior Literature

Google Founders’ IPO letter: “...In the transition to public ownership,we have set up a corporate structure that will make it harder foroutside parties to take over or influence Google. This structure willalso make it easier for our management team to follow the long term,innovative approach emphasized earlier. This structure, called a dualclass voting structure....”

Yet, a large part of the theoretical literature finds that dual-classstructures have negative effects on shareholders’ wealth.

I Optimality of one vote-one share ⇒ Grossman & Hart (1988), Harris &Raviv (1988, 1989)

I Why shareholders allow a dual-class recapitalization ⇒ Ruback (1988)I Issuance of dual-class shares in IPO’s ⇒ Bebchuck and Zingales (2005)

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Motivation

Recent empirical study...

Empirical research is mixed. It reports both positive and negativeabnormal announcement date returns for dual-class re-capitalizations

Masulis, Wang & Xei (JF 2009) use U.S. dual-class companies toexamine how divergence between insider cash-flow and control rightsaffects the extraction of private benefits.

I They find as the divergence in rights becomes largerF Average acquisition announcement return fallsF Average CEO compensation level rises

Interestingly, they find thatI between 1995 and 2003, for the 410 acquisition made by U.S.

dual-class firms, the 5-day CAR is +1.369% for the acquiring firm.

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Model Preliminaries

Our Firm

A typical publicly traded firm

Starts with one class of shares – the “commons.”I N common shares outstandingI Each common share has

F equal claim to cash flowsF equal voting rights.

I All participants are risk-neutralI Discount rate is zeroI All securities have prices equal to their expected payoffsI There are four players in our model

F The incumbent managerF Existing outside shareholdersF Potential new investorsF Potential rival manager

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Model Preliminaries

The Incumbent...

The incumbent is the one whoI Searches for new investment opportunities and conducts an initial

evaluation of potential investments.I Chooses investment projects to undertake

The incumbent maximizes the firm’s market value as well as his ownprivate benefits of control

I The incumbent’s public quality, aI , and investment decision, xdetermines a firm’s value

I The incumbent’s ability to extract private benefits, bI , and investment,x determines his private benefits

F Private benefits reduce the firm’s market value dollar for dollar

The objective function, wI (·), aI and bI are public knowledgeThe incumbent owns

I a large minority block – β N shares, where β < 1/2I is the largest shareholder, but is wealth constrained

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Model Preliminaries

Shareholders, Rival....

A rival’s abilities are unknown, the probability distribution of theseabilities is publicly known

Existing shareholders are the investors who own the firm.

New investors buy securities that the firm issues to finance its newinvestments.

Shareholders are able to influence broad corporate objectives throughsimple majority votes

I Security types the firm can issue to raise fresh capital (choice of equityclass)

I Changes in control of the firm

Each individual outside shareholder wants to maximize the value ofhis/her holdings.

The rival offers to buy the firm, if he values the firm higher than theincumbent (public value plus value of the private benefits).

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Model Preliminaries

Investment Opportunity

Our firm faces an new investment opportunity.

The new project generatesI public value for the shareholders (NPV > 0) andI private benefit that accrues to the firm’s manager.

No internal financing or debt financing is available; hence, the firmneeds to issue new shares to fund the new project.

Incumbent decides on a firm’s new investment level, x

The realized value of the project is “Investment + NPVi+ Noise” orx + ai P(x) + εx

I P(x) is concave and differentiable with a unique maximum at x̄I Manager-in-control

F Incumbent (I ) or Potential rival manager (R)F Productivity of managers vary: ai ∈ [0, 1] measures manager in

control’s ability to generate cash flows.

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Model Preliminaries

Private Benefits of Control

The manager-in-control appropriates some private benefit of control.

The realized value of the private benefit (Bi ) is fraction (bi ) of theNPV of the project (ai P(x))

I A higher level of investment produces higher private benefits for themanager-in-control.

I bi ∈ [0, 1] measures the manager-in-control’s ability to convert oneunit of NPV into his private benefit

Thus, the expected public value of the firm

FVi = Level of new investment + NPV of investment under

manager-in-control - Private benefits of manager-in-control

= x + ai P(x)− bi ai P(x) = x + (1− bi ) ai P(x)

Private benefits reduce the shareholders’ value, dollar for dollar.

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Temporal Evolution

Temporal Evolution of the Model

Incumbent-in-control Incumbent/Rival-in-control� �� � � �� �

t = -1

Shareholdersdecides on typesof securities toissue to raisefunds for newinvestments.

Manager decideson amount toinvest; if x > 0,then he sellsnew equity toraise funds.

New project isfunded. If notfunded at t=0competitors grabthe opportnity.

t = 0

Rival arrives. Iftakeover happens,then the rival is incontrol. Otherwise,incumbent retainscontrol.

t = 1

The firm isliquidated. Theshareholders getx + ai P (x) − Bias dividends. Themanager gets Bi.

εx, is uniformly distributed over the interval (−σx, +σx), with a mean zero and variance σ2x/3. P (x)is a concave function, differentiable everywhere with a unique maximum at x̄. Thus, the maximized

expected value of the new project is x̄ + ai P (x̄).

The parameter ai is a measure of the manager-in-control’s ability to generate cash flows from

the new project. Henceforth, we call the parameter ai “public quality” of the manager-in-control

at the end of the investment process, where the manager-in-control is either the incumbent (I) or

the potential rival manager (R). We assume that the public quality of the incumbent is common

knowledge and aI ∈ [0, 1]. Initially, the potential rival manager’s public quality is unknown; thus,we assume that aR is a random variable drawn from a uniform distribution with support 0 and

1. The lowest public quality manager is the one with ai = 0, and the resulting NPV of the new

project is 0. The highest public quality manager is the one with ai = 1, and the resulting NPV of

the new project is P (x).

Also, we assume that the manager-in-control (whether incumbent or rival) can appropriate

some benefits that are not shared by outside shareholders – a private benefits of control. This

private benefit is not verifiable; otherwise, if it is verifiable, it will be relatively easy for outside

shareholders to stop the manager from appropriating it. The realized value of the private benefit

is Bi = bi α ai P (x), where i = I, R. The parameter bi measures the manager-in-control’s ability to

convert one unit of NPV into his private benefit. Henceforth, we will call the parameter bi “private

quality” of the manager-in-control. We avoid the problem of over investment by assuming that

private benefits are also maximized at x̄. Like public quality, we assume that incumbent’s private

quality, bI ∈ [0, 1], is common knowledge and the potential rival manager’s private quality bR is arandom variable drawn from a uniform distribution with support 0 and 1. The parameter α is an

inverse measure of the effectiveness of “other outside private benefit monitoring mechanisms” that

can help, directly or indirectly, shareholders to access and/or prevent managers from converting

public value into excessive private benefits. For example, an effective income/consumption/wealth

disclosure system for government tax purposes and/or efficient legal system can act as an additional

deterrence to extracting excessive private benefits. The lower the effectiveness of such outside

monitoring mechanisms; the higher is the value of α. An α < 1 implies that the other monitoring

mechanisms in place are such that even the most “villainous” managers, bi = 1, cannot “convert”

the entire NPV into private benefits. See, for example, Dyck and Zingales (2004) and Nenova

(2003) for detailed discussions on estimates of private benefits.

7

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Control Contest

Control Contest: If voting shares are issued..

A change in control occurs when the rival can offer a higher per-sharevalue to outside shareholders than the incumbent.

If n1 voting shares are issued to finance the investment, then theincumbent retains control if

I The public value per share plus private benefit per outside share offeredby the incumbent is greater than the public value per share plusprivate benefit per outside share offered by any potential rival

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Control Contest

Control Contest: If non-voting shares are issued..

A change in control occurs when the rival can offer a higher per-sharevalue to the outside shareholders than the incumbent.

If n0 nonvoting shares are issued to finance the investment, then theincumbent retains control if

I The public value per share plus private benefit per outside voting shareoffered by the incumbent is greater than the public value per share plusprivate benefit per outside voting share offered by any potential rival

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Control Contest

Control Contest: Endogenous takeover bounds..

We can solve for the minimum ability of any potential rival to extractprivate benefits (bR), such that the incumbent retains control.

For any given values of the public qualities of the incumbent and rival(aI and aR respectively) and private benefit parameter of incumbent(bI ),

I if any potential rival’s ability to extract private benefit, bR is less thanbjR , then the incumbent retains control;

I otherwise, potential rival gains control.

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Control Contest

Decision Problem

The incumbent manager’s decision problem

maxx

[N β V jD (x) + φ

j bI P (x)]

.

The existing shareholder’s decision problem

maxj=0,1

V j1(x̂ j)

.

Both the manager and the outside shareholders are assumed to beinterested in maximizing their expected wealth.

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Results

Incumbent’s Holdings and Full Investment

When investments are financed by issuing voting shares and theincumbent does not own any equity in the firm (i.e., β = 0), then theincumbent invests in all available positive NPV projects.

I Zero ownership ⇒ no dilution of incumbent’s control rights if newvoting shares are issued

F Hence, there is no incentive to under-invest.

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Results

Underinvestment...

When the incumbent manager is forced to use voting shares to fund allnew investments and he has a strictly positive β so that new investmentdilutes his voting power, then the incumbent manager forgoes somepositive NPV projects if his ability to extract private benefits bI > b̂I ,where

0.1 0.2 0.3 0.4 0.5β

0.6

0.7

0.8

0.9

1.0

bI

As incumbent’s ownership increases, likelihood of underinvestmentdecreases. For more than 39% ownership, incumbent will neverunderinvest.

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Results

Why an incumbent may underinvest?

Managers with a relatively high ability to extract private benefits,bI >

12 , may under-invest if forced to issue voting shares to fund the

new projects.

MAXIMIZE Manager’s Expected Wealth = MAXIMIZE ExpectedDividend + Expected Private Benefit

Expected Private Benefit = Probability of Retaining Control ×Private Benefit of Control

If bI is large ⇒ the private benefit of control is large AND probabilityof retaining control decreases in the level of investment

Level of Managerial OwnershipI Zero ownership (β = 0) ⇒ No dilution in ownership ⇒ full investmentI Incumbent’s ownership rises (β > 0), which

F impact of ownership dilution increase leads to more underinvestmentF loss of dividends per share leads to less underinvestment

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Results

When do outsider shareholders like nonvoting shares?

For a level of private benefit extraction by the incumbent and theoptimal investment is not too large compared to the size of theexisting firm, outside shareholders prefer the investment to befinanced with nonvoting shares, if the loss due to underinvestment >the expected entrenchment costs (loss of takeover gains).Cost of allowing the manager to issue lower priced non-voting shares

I Lower per share dividend, since n0(x) > n1(x) ⇒ dividend dilutionI Low likelihood of control change, since the probability of retaining

control after issuing zero-voting shares to fund the new investment isweakly > the probability of retaining control after issuing voting sharesto fund the new investment.

Benefits to allowing the manager to issue non-voting sharesI Higher investment in positive NPV projectsI Higher takeover premiums, conditional on a takeover (for voting shares)

Shareholders will voluntarily allow the incumbent to issue non-votingshares even if the under-investment is small because

I The takeover premium conditional on a takeover is potentially large.

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Results

Control Inefficiencies are Real!

The minimum public quality of the incumbent manager required forhim to retain control of the firm is lower in firms financed withdual-class shares.

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Conclusion

Conclusions

If a firm, with positive NPV projects, requires equity financing toundertake new investments, then separation of the vote and dividendclaims at times is optimal. Raising equity capital has two effects:

1 Firm value increases since positive NPV projects are funded2 Proportion of voting shares owned by the manager decreases,

increasing the likelihood that he loses control.

A manager, who values control, finds it optimal to forgo somepositive NPV projects.

I Non-voting shares can alleviates this control related under-investmentproblem.

Outside shareholders, at times, may find non-voting share issuanceattractive, because

I The benefits of more profitable investments and a higher expectedtakeover premium outweighs the costs of managerial entrenchment.

Finally, our results generalize to low voting shares instead ofzero-voting shares.

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MotivationModel PreliminariesInvestment OpportunityPrivate Benefits of ControlPublic Value of the Firm

Temporal EvolutionControl ContestIf voting shares are issued...If nonvoting shares are issued..Probability of Incumbent Manager Retaining Control

ResultsConclusion